Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Diagnostic Medical Systems S.A. (EPA:DGM) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Diagnostic Medical Systems Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2021 Diagnostic Medical Systems had €10.3m of debt, an increase on €7.52m, over one year. On the flip side, it has €2.20m in cash leading to net debt of about €8.14m.
A Look At Diagnostic Medical Systems' Liabilities
Zooming in on the latest balance sheet data, we can see that Diagnostic Medical Systems had liabilities of €19.6m due within 12 months and liabilities of €10.7m due beyond that. Offsetting these obligations, it had cash of €2.20m as well as receivables valued at €10.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €17.2m.
This deficit is considerable relative to its market capitalization of €20.6m, so it does suggest shareholders should keep an eye on Diagnostic Medical Systems' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Diagnostic Medical Systems will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
In the last year Diagnostic Medical Systems wasn't profitable at an EBIT level, but managed to grow its revenue by 3.8%, to €37m. We usually like to see faster growth from unprofitable companies, but each to their own.
Over the last twelve months Diagnostic Medical Systems produced an earnings before interest and tax (EBIT) loss. Its EBIT loss was a whopping €3.1m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. Another cause for caution is that is bled €8.2m in negative free cash flow over the last twelve months. So suffice it to say we consider the stock very risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Diagnostic Medical Systems you should be aware of, and 2 of them can't be ignored.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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